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Canada needs sound fiscal thinking, not balanced budget laws

on Jan 28, 2014 at 4:21 PM Posted by Andrew Jackson

In last year’s Speech from the Throne, the Harper government promised to introduce legislation to require “balanced budgets during normal economic times, and concrete time lines for return to balance in the event of an economic crisis.”

This proposed legislation makes little sense in terms of sound economic policy. But it will likely be introduced as part of the federal budget, expected early next month.

Former senior Department of Finance officials Scott Clark and Peter de Vries note in a similar vein that balanced budget legislation in other jurisdictions has had no practical effect, and that the motivation for such a law is political. They argue that the real Conservative aim is to convince their base that they are still fiscal conservatives, even after having run a series of large deficits.

Most economists would agree that budgets should be balanced over the course of the business cycle, such that deficits maintain output and jobs in recessions, but are offset by surpluses in good times. And most think, with good reason, that the big deficits run by Canada and other countries from 2008 helped contain a crisis that could have easily turned into a 1930s-style economic disaster.

There is much less agreement about what are “normal times” in which budgets should be balanced, and what should be the stance of fiscal policy at any given time.

Thinking about the recent past, Canada experienced no recession in the almost two decades between the early 1990s and 2008. Over this period, the federal budget was brought from deficit back into balance by 1997-98, and surpluses were run for a decade until 2008-09. As a result, the federal debt fell from 67 per cent to 33 per cent of GDP on a public accounts basis.

While many applauded the determination of Finance Minister Paul Martin to balance the books “come hell or high water” in the mid-1990s, the fact is that the economy was hardly operating at anywhere near full capacity when deep spending cuts were imposed in the 1994 and 1995 budgets. The national unemployment rate was 10.4 per cent in 1994, and did not fall below 9 per cent until 1998.

Had it not been for low interest rates, the low Canadian dollar and growth in the United States, Canada’s still very tentative recovery from the deep recession of the early 1990s would have been derailed by very tight fiscal policy. A durable recovery did not really begin to take hold in the job market until after the 1990s.

Conversely, when the Harper government took office in 2006, the national unemployment rate stood at just 6.3 per cent, on its way to a 2007 low of 6 per cent, and the federal surplus was $13.7 billion. Rather than use the surplus to reduce the debt in good times so as to help meet the looming costs of an aging society, Finance Minister Jim Flaherty blew almost all of the big surplus he inherited by cutting the goods and services tax (GST) rate, in two steps, from 7 per cent to 5 per cent.

By most calculations, notably those of the Parliamentary Budget Office, the Harper Conservatives created a structural deficit just before we hit the Great Recession. They may do so yet again if, having balanced the books by 2015, they introduce a major new round of tax cuts in the form of family income splitting and higher levels of tax-free savings. These measures will cost well in excess of $3-billion in lost annual revenues.

The actual conduct of fiscal policy in Canada has, then, often been significantly at variance with the conventional prescription of economists to run deficits in bad times, balanced budgets in normal times, and surpluses in good times.

While some might say that this is an argument for binding fiscal rules, “responsible” fiscal policy is surely in the eye of the beholder, and a matter for political and expert judgment.

There is lively debate in most advanced economies today regarding the need for the austerity measures favoured by fiscal conservatives, which are slowing a very weak recovery. In the United States, prominent economists such as Paul Krugman, Joseph Stiglitz, and Larry Summers argue for higher deficit-financed public investment to reduce high unemployment.

Here in Canada, with unemployment on the rise and employment levels still significantly below where we were in 2007, there is a strong case that fiscal policy should be adding to, rather than subtracting from, growth. Many economists agree that, with a low level of public debt and low interest rates, there is no need for Mr. Flaherty to rush to balance the federal budget.

The appropriate stance of fiscal policy should be debated on its merits, taking into account changing economic circumstances. It is foolish to believe that legislation to impose fixed rules can take the place of political choice and judgment; such rules run a high risk of mandating ill-judged policies.